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August 28, 2013

Congress Girds for Another Debt Fight as Deficit Shrinks

Lawmakers must also decide whether to replace about $1 trillion in sequestration cuts

Congress has a lot on its plate when it returns on Sept. 9 from its August break. On top of renewing talks on a stopgap measure to fund the government in the first few months of the fiscal year that starts Oct. 1, lawmakers must decide whether to raise the government’s $16.7 trillion debt limit, and replace about $1 trillion in the across-the-board spending cuts of sequestration.

The Obama administration is also likely to nominate a new Federal Reserve chairman this fall, as current Fed chief Ben Bernanke is set to step down when his second term ends in January.

PIMCO analysts Libby Cantrill and Josh Thimons predict in a recent commentary that unlike the last continuing resolution, which was passed in late March with little consternation, “this time congressional leaders seem to be steeling themselves for a larger fight.”

Republicans want to fund discretionary government spending at levels stipulated by the sequester cuts and spending cap levels in the Budget Control Act (the 2011 debt ceiling compromise) of $967 billion, the two analysts say, while Democrats want to effectively replace the sequester and fund the government at a higher amount of $1.058 trillion, a difference of $91 billion.

Cantrill and Thimons predict that while “bluster and posturing will abound,” ultimately a short-term deal to fund the government will be reached and a government shutdown averted.

As to raising the debt ceiling this time around, it will include lots of drama, the two PIMCO analysts say. Speaker of the House John Boehner is “pushing for a similar debt ceiling deal to the one agreed to in 2011 — effectively a one-for-one cut in federal spending for each dollar increase in the debt ceiling.” But President Barack Obama and congressional Democrats have insisted they will not negotiate over a debt ceiling increase.

Indeed, Joe Lieber of Washington Analysis says that the "real fireworks" will not occur at the end of September, when a continuing resolution needs to be passed, but rather closer to the mid-October debt limit date.

"We have long believed that Republicans will try (we think successfully) to pass a short-term CR that funds the government up to the debt limit deadline (in this case mid-October), so that both the CR and debt limit need to be addressed at the same time," Lieber says. "Republicans want to do this for two reasons: (1) they believe they will have more leverage if the two are intertwined; and (2) President Obama and his administration continue to insist that they will not negotiate over the debt ceiling."

If the two are intertwined, however, Lieber argues, "the administration can negotiate with Congress but say that it is with respect to the CR, and not the debt ceiling."

The two PIMCO analysts predict, however, that a debt ceiling resolution will ultimately be reached, but will likely follow the pattern of nearly every other recent fiscal negotiation: “demagoguery and brinkmanship up front, followed by a deal cobbled together at the eleventh hour.”

Indeed, Lieber agrees that while some type of "small compromise" will be worked out that likely "provides a face-saving move for both Democrats and Republicans," Republicans will "not get a dollar in spending cuts for every dollar increase in the debt limit, but some small deal that might even include minor entitlement changes is likely."

While these economic policy debates in Washington have “important ramifications for investors,” the PIMCO analysts say, “and could drive market volatility higher in coming months,” the markets now expect “very little out of Washington and have become accustomed to politicians taking us to the brink of fiscal catastrophe.”

But John Canally (left), economist for LPL Financial, writes in an economic commentary released Tuesday that the federal deficit, at $725 billion, is currently at its lowest level since late 2008. But the budget picture could take a turn for the worse depending on how Congress tackles the aforementioned economic issues, he says.

An improving economy, stronger labor market, spending cuts from sequestration and tax increases are all contributing factors to the shrinking deficit, Canally says.

The Congressional Budget Office continues to project that the budget deficit in FY 2013 will total $642 billion, which amounts to about 4% of GDP, he says.

A number of factors are driving the improving deficit, Canally says.

First is that year to date, federal revenues are up 14%, while spending is down nearly 4%.

Also, personal income taxes account for roughly 50% of federal revenues while taxes withheld for Social Security and Medicare account for 35% of federal revenues.

A better labor market — with 2.3 million net new jobs created over the past 12 months — and rising wages (wage and salary income, as measured by the monthly report on personal income and spending, is up 4% year over year), account for some of the gain.

The expiration of the Social Security payroll tax cut in January and the increase in tax rates for incomes above certain thresholds have boosted revenues.

The rising equity market has also accounted for some of the gain in individual tax revenues: equity markets hit new all-time highs in the first half of 2013 and investors may set aside tax payments after exercising stock options or selling stocks.

Corporate profits are at record levels and corporate tax receipts are up 17% in the first 10 months of FY 2013 versus the similar period in FY 2012. Corporate tax receipts account for 10%-15% of federal tax revenues.

Canally warns, however, that an “otherwise positive budget picture” thus far could be cut short if policymakers continue to ignore the following “warning signs.”

The “risk,” he says, “is that Congress and the general public will be distracted by the rapidly improving near-term budget outlook, and will not address the longer-term structural budget problem quickly enough to head off a worsening, long-term budget deficit.”

The first warning sign, he says, is that FY 2013 to date, federal spending on mandatory programs (payments set by formula written into the law) like Social Security, Medicare and Medicaid “is running above the pace of nominal GDP growth.”

Also, federal spending on Social Security benefits is up 5.4%, “nearly twice the rate of nominal GDP growth over the past year (2.9%),” he says. “Similarly, spending on Medicare is up 3.0% in the first 10 months of FY 2013, while Medicaid spending is up 5.7%, also about twice the rate of nominal GDP growth.”

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